After my initial post, I got an email suggesting that I put too much emphasis on the liquidity problem, and not enough on the insolvency problem. There's been something of an ongoing discussion on this point on various websites, and even the Wall Street Journal got into the act a few days ago, talking to Milton Friedman's co-author on A Monetary History of the United States, Anna Schwartz, who makes the point that the problem absolutely is an insolvency issue, while it appears that much of the federal bailout is focused on dealing with a liquidity problem.

So, what's the difference? In simple terms (and, yes, I'm sure the super finance types may quibble over the specifics, but this should get the broad strokes correct), liquidity problems occur when an entity owes money but doesn't have readily available cash to pay off those debts. They may have other assets, and generally speaking, if they're facing a liquidity problem, they're likely to try to sell off those assets, potentially below cost, just to get the money they need to pay off their debts. Say, for example, you owe $100 for your car loan each month, but don't have the cash to make the payment. You might try to sell something else you own to get that cash, and if you're desperate enough, you may even sell something for less than it's worth, just to get the cash and avoid defaulting.

But much of the problem in the financial world over the past few weeks hasn't been a lack of liquidity but an unwillingness to lend. That is, the banks have a ton of cash on hand, but they're afraid to give it out to anyone, because they don't know if whoever they lend it to will still exist when it comes time to repay. So, instead of lending it out, they're dumping it into the safest of safe investment vehicles: US gov't treasury bonds, even though they pay almost no interest. As the good folks on Planet Money note, treasuries are about the equivalent of stuffing the money into your mattress. You won't lose the money, but you won't make any interest either.

Basically, many of the banks have liquidity (cash), but are so afraid that the others they lend to are insolvent (unable to pay back loans) that they won't loan. That's why you may have heard more and more people talking about the (until recently) obscure "TED spread," which basically represents the difference between the interest rate at which banks are lending to each other (the LIBOR -- or London InterBank Offered Rate) and the interest rate on US treasuries. It's a quick measure to determine how secure banks feel about lending to each other vs. putting money in the proverbial mattress. In normal times, this is pretty small, because lending short term money out to other banks is considered pretty damn safe -- almost as safe as lending to the US government. So, it's usually well below 1%. Over the past few weeks, it's been sitting above 4%, on many days -- which basically means that banks are simply sitting on their cash because they don't trust other banks at all. This week, it finally started dropping, representing at least some easing of concern (though it's still pretty high).

So, as you can see, there's plenty of money in many of these banks, suggesting that they're not so worried about liquidity, but the solvency of everyone else they deal with. Of course, the two things overlap a bit. A bank that doesn't have liquidity may then be considered insolvent as well. On the good side, it looks like the federal government is finally recognizing the difference between liquidity and solvency and is trying to deal with the solvency issue by effectively agreeing to buy up commercial paper from money market funds. Basically, the issue here is that the commercial paper market has been standing still. As we described in our earlier post, this is the short-term lending that goes on between companies all the time, and is important for their liquidity. But with the money market managers afraid of insolvency, they're unwilling to lend money out, if there's not enough evidence they'll get it back. So, now, the government is basically saying, "go ahead and lend it out, and we'll make sure that it gets paid back." That could present a huge risk in terms of pushing the market to do bad loans and stick them to the US government, but as a short-term measure it can certainly help in kick-starting the market. Unfortunately, there are already some complaints that the rules are way too confusing.

That said the real problems touch on both liquidity and solvency, so the real solution needs to deal with both. If we don't deal with the worries over solvency, then we'll have a much bigger liquidity problem across the economy. Because the banks are afraid to lend money out, lots of companies are unable to then get the money they need for daily operations -- and then they become insolvent, creating a disastrous domino effect. Those with money are afraid to lend it, because they're afraid they won't get it back -- and their unwillingness to lend is making it so that others really can't meet their obligations. So, while there's some argument about solvency vs. liquidity, a solvency problem at one part of the chain can create a liquidity problem elsewhere, which in turn leads to solvency problems. This is why it is rather important to get those with money to get it moving again, or it very much is like an engine running out of oil. Just dumping money into the market can help somewhat, but until recently, it was mostly going to banks who already had cash, but weren't lending it.

So, what's it all mean? Well, as of today (and these things are changing pretty quickly), the past few weeks showed that no one was lending to anyone as they all seemed to fear that the folks on the other side wouldn't be around or able to give the money back within the next three months or so. That created a pretty significant risk of limited cash flow problems. The initial moves by the gov't with the bailout didn't seem to do much to deal with that problem, but its more recent moves suggest it now recognizes the real issue and will do what's necessary to fix it. My fear, at this point, is that in typical government fashion, it turns the spigot too far, leading to a situation where, in order to force liquidity into the rest of the market, we end up encouraging and paying for bad loans.

Needless to say, this is still a pretty complex situation, and while it looks like we may have (so far) avoided the worst case scenario, there's reason to be afraid that in all the knob spinning the Fed is doing, we're going to end up overshooting in both directions at points, and that can be just as dangerous in simply delaying inevitable pain.

Our Economy Shouldn't Rest on Banks Lending to other Banks

It should rest on Banks lending to businesses and consumers. And that is the problem. Financial services are secondary industry -- i.e. they don't exist without other primary industries (food, housing, clothing, etc...). The fact that our economy has become dependent upon financial services to operate indicates a systemic flaw in our economic architecture.

Pumping liquidity causes illiquidity

The fed is causing the high interbank rate.
If banks can borrow from the fed, then why would they risk borrowing from each other.
Banks trying to borrow from other banks must REALLY need the cash, so they are more risk, therefore the higher rate.

As an aside, LIBOR is a bad indicator at the moment. If not many banks are lending at that rate then you have to question it's relevance.

Re: Almost forgot

Looks like capitalism reigns supreme; 90% of the world’s population holds less than 1% of the wealth, which means 99% of the wealth of the Earth is currently held by 10 per cent of the world’s population. Redistribution of wealth would have most likely saved many of past great societies of the world from failing. The Romans, Egypt, and many other that I am sure you all know of.

Re: Pumping liquidity causes illiquidity

Re: Our Economy Shouldn't Rest on Banks Lending to other Banks

Agreed, Jake.

Yesterday, I sat through the House Financial Services Committee meeting, where it was proposed by Banking industry interests that there be a Global Regulator on CDO and CDS instruments. Global. As in the foundation for a world-wide banking system.

The banking industry acknowledged a "systemic collapse" (interesting key word, used several times) of the perceived value of such CDO and CDS instruments, but there was also hope that the next injection of the $700B Bailout would go to less risky loans via the existing Small Business Administration.

Now, this in itself isn't that bad of an idea because small/medium sized business (1-10 being small, 10-100 being medium, in my mind) do a good job of acquiring local talent and providing training and solid benefits as necessary.

This benefits the local community by providing gainful employment, tax dollars, and good benefits for employees.

It's very important to note that it was Democrats that were pushing these ideas. I expect McSame to take it, put out a bunch of ads claiming giving money to small business via SBA, claiming it as his idea, starring America's favorite man, Joe The Plumber.

I can't stress this enough: No Republicans were present (at least during these discussions), and strengthening the SBA is a Clinton-era ideology.

Re: Re: Our Economy Shouldn't Rest on Banks Lending to other Banks

The banking industry acknowledged a "systemic collapse" (interesting key word, used several times) of the perceived value of such CDO and CDS instruments

The ratings agencies are at the heart of this liquidity crisis, but few people acknowledge this. Ratings agencies like Moody and Fitch permitted a CDO composed of high-risk BBB-debt to have a low-risk "super senior tranche". Now the market for CDOs has become something of a game of duck, duck, goose. Nobody wants this stuff because they don't even know if highly rated CDOs are safe, the market shuts down, and you end up sitting on assets that you can't sell without taking a huge loss - illiquidity. Morgan Stanley actually sold a super-senior tranche for 22 cents on the dollar back in July.

Mise En Place

So much for outsourcing. The Real economy grows as a proportion of...guess what...reality.
If I could add up the advantages inherent in 10000000 times leverage, I would be considered a retard. Just like anybody who thinks our military capability is worthless.
Buy gas, it's deliverable.

Hmmm...

Balance Sheet lesson- current ...

Balance Sheet lesson- current assets are those which are likely to covert to cash within 1 year. Current liabilities, like PAYROLL , will need to be paid in 1 year. The ratio between the two gives an indication of solvency. Long term debt is factored in by determining that portion of the LT debt which will be due within a year and including that in current liabilities. A rule of thumb is 2:1 assets over liabilities. This is the quick and dirty method to determine solvency. It is the ability of the company (or individual) to meet their current obligations.

The system is sick

Thanks for your clarification of those terms. As someone with a background in medicine and NOT economics, I found it helpful. A physiological analogy occurred to me. When a previously healthy patient has a drop in blood pressure due to trauma and hemorrhage, a standard part of the treatment is rapid intravenous replacement of the lost fluid while you patch up the bleed, and as long as you act quickly, you can prevent long-term damage to the organs depending on the blood supply. I suppose that patient would be your liquidity crisis. If, however, a patient has low blood pressure because of heart failure (maybe because of a virus, maybe because of chronic uncontrolled hypertension ...), the treatment is quite different--the last thing you want to do is give him fluids, because his heart is basically unhealthy. I suppose that would be insolvency. In the latter patient, any additional fluids you give will just accumulate in the tissues, causing all kinds of other complications. I fear that our current financial system is more like the latter patient. One could say that it had both chronic hypertension (overheated markets, excessive debt) and a malignant virus (CDS's). We may be able to alleviate the symptoms with medications for the time being, but if it's going into terminal organ failure, the only definitive cure is a transplant. (I'll leave it to someone else to figure out the economic analogy for that.)